New Fed mortgage rules tighten mortgage practices

The federal government has put its foot down: A lender can’t give you a subprime mortgage unless you are able to repay it. And that goes for jumbo mortgages, too — maybe.

You’re probably wondering why the feds find it necessary to tell lenders that they shouldn’t hand over the money before figuring out whether borrowers can afford the monthly mortgage payments. That seems awfully basic. But for a while, verifying a borrower’s ability to pay was out of fashion.

Like bell-bottom jeans, the practice of verifying a mortgage borrower’s ability to repay was wildly popular when Led Zeppelin ruled the airwaves, then became hopelessly uncool, and now is popular again.

Subprime loans used to be hot. Now they’re not. Subprime lending barely exists, because so many of the loans went bad. From 2003 until last year, stated-income loans were the big fad, because they allowed borrowers to exaggerate their incomes without having to provide contradictory documentation. Now stated-income loans are rare because they’re deemed too risky. They were called “liar’s loans” for a reason.

Now, more than a year after stated-income and subprime loans fell out of favor, the Federal Reserve has banned stated-income subprime loans.

Lenders will have plenty of time to adapt to the new rules. They don’t go into effect until Oct. 1, 2009.

New “higher-priced” loans

The Fed’s new rules divide mortgages into two categories: “higher-priced” loans, and everything else. The “higher-priced” category is the Fed’s way of defining subprime mortgages, which generally go to people who have had trouble paying their bills on time. Some of the new rules apply only to this “higher-priced” category.

With its new “higher-priced” category, the Fed designed a net to capture subprime loans, but some jumbo mortgages might get caught in it, too.

Under the new rules, you can’t get a higher-cost loan unless the lender decides that you can afford the highest scheduled payments during the first seven years of the loan. This means that if you get an adjustable-rate mortgage, you have to be able to afford the payments at the highest possible rate.

The rules ban prepayment penalties for higher-cost loans if the rate can change in the first four years. In any case, prepayment penalties can’t last more than two years. And higher-cost loans have to have escrow accounts for property taxes and insurance.

Some rules apply to all mortgages, not just high-cost loans. Lenders and mortgage brokers “are prohibited from coercing a real estate appraiser to misstate a home’s value.” Servicers have to credit your account when the payment is received and can’t play games with late fees. Lenders have to give fee estimates for refinances and equity loans.

Positive response

or the most part, banks and consumer advocates say they like the Fed’s new standards. The president of the consumer group ACORN wishes they had come sooner, though. “The overall proposal would have been better if initiated several years ago, when many of these bad, unaffordable loans were originated by unscrupulous brokers,” ACORN chief Maude Hurd says.

Joe Belew, president of the Consumer Bankers Association, says he hopes “the Fed’s new mortgage regulation helps pave the way for the reemergence of healthy, sound subprime lending to deserving borrowers.” That paving project might take a long time, as the revival of the Federal Housing Administration, or FHA, has captured the market that used to be subprime.

Jumbos treated as subprime?

The chairman of the Mortgage Bankers Association sounded a cautionary note, saying that the group “is carefully reviewing aspects of the rules including the new standards for determining which loans are treated as subprime.” The concern is that jumbo mortgages for people with excellent credit could be treated as subprime, which was not the Fed’s intention.

The definition of “jumbo” already is complicated. Last year, a jumbo loan was a mortgage for more than $417,000. Now that upper limit has been raised, temporarily, in some markets. In the most expensive places, such as Los Angeles, a jumbo loan is a mortgage for more than $729,750.

Last August, the secondary market for jumbo mortgages melted down when investors suddenly realized that they hadn’t understood the risks inherent in the jumbo loans they owned. The jumbo market was like a Looney Toons character who runs off a cliff and keeps running until he looks down. It hasn’t climbed all the way out of the abyss yet.

As a consequence, interest rates on jumbo loans are higher than they once were. Jumbo rates are so high that they could occasionally stray into the Fed’s “higher-cost” territory.

The Fed will use Freddie Mac’s weekly mortgage rate survey as a benchmark. Any first-lien mortgage rate that exceeds the comparable Freddie Mac rate by more than 1.5 percentage points would be deemed higher cost. By that standard, many jumbo loans would be higher cost.

Last week, Freddie’s average rate for a 30-year fixed was 6.37 percent. Any 30-year, fixed rate mortgage higher than 7.87 would be considered a higher-cost loan, under the new rule.

Freddie Mac doesn’t (yet) survey jumbo mortgage rates, but Bankrate does. The nation’s biggest jumbo mortgage market is Los Angeles. Last week, of the 10 institutions that Bankrate surveyed in Los Angeles, nine offered 30-year, fixed-rate jumbo loans. Four of them charged rates higher than 7.87 percent. (Bank of America and Citibank were highest, at 8.5 percent.) Five institutions offered jumbos below the Fed’s trigger rate. One of those lenders was IndyMac, which has since been taken over by the FDIC.

The Fed is aware of the issue, and says: “While covering prime jumbo loans is not the Board’s objective, the Board does not believe that it should set the threshold at a higher level to avoid what may be only temporary coverage of these loans relative to the long time horizon for this rule.”

No misleading ads

The Fed laid down a few other rules, too. Those mortgage ads on AM radio will have to change, because the Fed has banned misleading advertisement practices, such as touting a rate or payment as “fixed” when it can change.

Most controversially, the Fed changed its mind (for now, at least) on yield spread premiums, or YSPs. A yield spread premium is a commission that a mortgage broker gets for signing a borrower up for a higher rate. YSPs have their uses. Besides compensating brokers, the money can be used to pay some or all closing costs. If you got a no-fee mortgage when you bought your house, you paid a higher rate, and the fees were taken out of the yield spread premium. (If you used a bank and not a broker, the equivalent to a YSP is called a servicing release premium).

When the Fed proposed these rules in December, it wanted to ban yield spread premiums unless the borrower and broker agreed to a YSP amount up-front. It would have been like locking in a car salesman’s commission before picking out which vehicle you wanted.

Mortgage brokers complained, and the Fed says it conducted tests of YSP disclosures, and discovered that they confused borrowers. The Fed says it will “consider alternative approaches” to regulating yield spread premiums.

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